Why Do Standard Setters Make Such Awful Decisions?

Everyone, it seems, likes to complain about the decisions of the FASB and IASB. Some complain that the Boards are too beholden to the wishes of preparers, by allowing them to park debt off their balance sheets, hide volatile income numbers in the Statement of Changes in Shareholder’s Equity (rather than running through earnings), and delay taking impairments on a timely basis. I am not sure I agree with these criticisms, but they form a plausible and coherent story: Standard setters aren’t necessarily dumb, they’re just greedy. Since this is an academic blog, instead of saying ‘greedy’ I will say they have succumbed to a form of ‘regulatory capture‘, which suggests that standard setters are being rational, but self-interested, and their self-interest lies in advancing the interests of the parties they regulate (the preparers).

But this story doesn’t work nearly as well for the criticisms of standard setters coming from the academic community.

Many academics have a completely different set of complaints, arguing that the FASB and IASB are making serious mistakes by eschewing conservatism and embracing fair value reporting. And, to hear many academics say it, these positions aren’t just misguided, they are awful and indefensible. I recall Zoe-Vonna Palmrose, in a very well-attended panel discussion at the AAA, using children’s stories and hand puppets to imply (if not explicitly state) that even children could understand the problems with fair value accounting.* Watts has made the point that conservatism and verifiability are bedrock aspects of accounting for hundreds of years, so the Boards are turning their back on time-honored traditions that work well. Ohlson and Penman rely heavily on ‘common sense’ in justifying their alternative conceptual framework. And I can’t count the number of colleagues who have told me (as Ohlson and Penman as primary authors for an AAA-FASC report) that the Boards are crazy to focus on assets and liabilities, instead of focusing on a meaningful income number.

What I find remarkable about these criticisms is that they don’t seem well-explained by regulatory capture. Many preparers, if not most, are strongly opposed to fair value accounting, which they see as expensive and impractical. I suspect that many preparers also prefer conservatism in accounting standards, which allows them to show smoother earnings (especially when they have flexibility in reserves, which they typically do). Preparers certainly don’t care for the asset-liability approach, which generally puts highly volatile numbers (fair value changes) into the income statement.

Perhaps the Boards are worried more about the SEC or Congress than about the preparers. But Watts, in his analysis of ‘what the invisible hand has achieved’ in accounting, implies that political pressures should lead accounting policy-makers to be conservative, not neutral, and to embrace verifiability rather than speculation—exactly the opposite of what the Board is doing. So it seems unlikely that the Boards’ positions on these matters are simply politically expedient.

Let me emphasize, I am not saying that my academic colleagues are wrong on the substance of what good accounting standards should look like. Fair Value accounting has its problems, conservatism does have a long tradition, and users do seem to want meaningful measures of persistent income. I think the academics have defensible positions. My question to those who back these criticisms is: why do the standard setters seem to make such awful decisions?

It isn’t to curry favor with preparers, who seem to largely agree with the academics (but perhaps I am mistaken on what preparers prefer).

It isn’t to protect against SEC or Congressional action.

Perhaps it is to curry favor with financial statement users, like the CFA Institute. But wouldn’t that be exactly what the standard setters should be doing? Unless, of course, the users are dumb themselves, and don’t know what they want. But that is not an argument I would expect to hear from many of the academic critics, who are also adherents to the Efficient Markets Hypothesis.

What am I missing?

*UPDATE: Bill Kinney informs me my recollection is flawed — Zoe-Vonna did tell stories, and use voices for different characters, but as far as he recalls, did not use hand puppets. Also, she did not tell children’s stories, but instead performed a skit/dialog with introductory accounting students. Thanks to Bill for correcting the record. However, I think my basic point goes through unchanged: Zoe-Vonna implied that the errors of the FASB’s ways were so obvious that even introductory accounting students could identify them…again, begging the question of why the Board would make such decisions.

Robert Bloomfield

Robert Bloomfield is the Nicholas H. Noyes Professor of Management and Accounting at the Johnson Graduate School of Management at Cornell University, where he has taught and conducted experimental research since 1991.

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2 comments on “Why Do Standard Setters Make Such Awful Decisions?”

You raise some interesting questions. Here’s an article by a law professor at Georgetown, who considers the question of regulatory capture and argues that the FASB has largely been able to resist capture.

Here is the (somewhat long) abstract in its entirety. I quote the entire abstract because it not only touches on the idea of regulatory capture, which is Rob’s point, but it also relates to the topic of today’s Round Table, “Alternative Conceptual Frameworks”.

Abstract:
The Financial Accounting Standards Board (FASB) presents a puzzle for those interested in the design of private governance institutions: How has this private standard-setter managed simultaneously (1) to remain independent and free of capture, (2) to achieve institutional stability and legitimacy, and (3) to operate in a politicized context in the teeth of opposition from its own constituents? This Article looks to governance design to account for this institutional success. The FASB’s founders made a strategic choice between two models of a public regulatory agency, the New Deal model of an independent expert and the post-war pluralist model of a politically responsive regulator. They opted for the New Deal model, structuring the FASB to emphasize independence. Because the New Deal model calls for a normative goal to channel the agency’s exercise of discretion, they also undertook to set out a coherent theory of accounting, the “Conceptual Framework,” to contain and direct the FASB’s decisions and thereby import legitimacy. The Conceptual Framework, however, neither determined nor justified the FASB’s subsequent decisions. It nonetheless contributed to the FASB’s institutional success by disavowing a neutral posture respecting the conflicting interests of the FASB’s leading constituents, explicitly privileging the interests of the users of financial reports (investors and market intermediaries) over the interests of the reports’ preparers (large firms and their managers). The FASB’s consistent adherence to this repudiation of pluralist responsiveness has had three results. First, it made the FASB’s general approach defensible as a matter of economic theory. Second, it triggered political opposition from the preparers that muted allegations of capture even as it resulted in occasional political reversals. Third, it aligned the FASB’s institutional mission with that of the SEC, its public overseer, importing institutional stability if not political invulnerability.

The FASB remains vulnerable to a secondary capture allegation. Critics charge that its complex, rules-based standards serve the audit firms’ interest in lowering the risk of liability while sacrificing the users’ interest in “fairly” stated financials; “principles-based” standards would be better. This Article endorses the rejoinder position. What some see as capture also can be characterized as “responsiveness,” and the FASB serves a public interest in taking seriously the accounting firms’ need for auditable standards. Even as detailed rules can distort the overall story told by a report’s bottom line, they make it easier to see what preparers are doing, easing verification and making audit failures and scandals less likely. In this post-Enron era, scandal prevention arguably takes a legitimate place with transparency as a public-regarding goal for the GAAP setter. The FASB emerges as a generator of suboptimal but institutionally-defensible standards. If not ideally legitimate, the FASB has been legitimate enough.

The AAA Committee comment letter is indeed thought provoking. Here are my first reactions in no specific order:

As I read the letter, I asked myself how Ross Watts could endorse this. Principles C and D taken together would largely remove what we academics refer to as conditional conservatism – the principles would not allow for accelerated recognition of losses to the current period when the company receives bad news about the future. In the end, I see Ross dissented.

The biggest internal inconsistency I see is principle A (the company needs a transaction to trigger recognition and measurement) and principle C (centrality of operating earnings measurement). In A, the authors focus on verifiability of an actual transaction as a cornerstone in accounting. But in C, in order to achieve a measure of permanent income, they recommend that the income statement separate recurring items from non-recurring items. They further endorse income smoothing (e.g., p. 15, “standards should allocate firms’ operating expenditures over periods in a consistent fashion without arbitrary lumps”). Who assesses recurring versus non-recurring and/or how much smoothing is appropriate for a given firm in a given year? Does the standard setter identify a list of transactions (consistent with principle A) that should always appear in the recurring section of the income statement and any transaction that is not on the list should appear in non-recurring? Or does management assess whether the transaction is likely to recur given the firm’s business model? If the latter, then income measurement appears to hinge on managment’s “subjective assessments of expected future dollar amounts (p. 9),” which is contrary to principle A.

In my view, income smoothing depends on facts and circumstance beyond the details in a specific transaction, and depending on who is doing the smoothing, the “correct” amount of smoothing is likely to be unverifiable. Ross Watts seems to raise a similar issue in his communication (p. 24). So I would like to hear more discussion of how principles A and C can coexist in practical settings.

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